Hall Capital “Market Views” Newsletter July 2022

This is the 49th edition of Market Views from HALL CAPITAL. Our aim is to provide concise views of where we see risk and opportunity for investors.

Inflation or Recession?
- or both

When the economy is overheating, but the remedy (higher interest rates) increases the risk of recession, it is difficult to hedge against both outcomes. So many investors have simply sold stocks and raised cash, driving the S&P 500 down -20% for the first half.

While we are optimistic that inflation will peak soon, we think that labor and rents will keep inflation stubbornly higher than Fed targets for some time. And with rising interest rates taking its toll on economic activity, the odds of a recession in the next 12 months are now well over 50%. In fact, in every case when the Fed raised interest rates aggressively in the face of rising inflation, a recession has occurred within two years.

So we remain defensive, hedging more against inflation than recession. We think persistent high inflation is the bigger problem as recessions can come and go with some regularity.

Why Not Move to 100% Cash
- given the risk of stagflation

Here are four reasons not to: 1. Even with a recession or inflation above the Fed target of 2%, the long term expected return from equities is still well above cash and bonds; 2. Sentiment - both investor and consumer - is VERY negative, which is more consistent with being close to a market bottom; 3. Moving 100% implies great conviction. I am never 100% sure of ANYTHING. If the market turns up, missing some of the turn is ok, but missing out entirely and having to put 100% to work at higher prices sets up a potential major whipsaw; 4. There is already a lot of cash on the sidelines. Thus, it will not take much good news to spark the market higher.

Other than peace suddenly breaking out in Ukraine (unlikely) or China opening up, the best good news would be material improvement on inflation. While the market will rally on this, we think the rally will be limited in the near term as we do not believe our inflation problem will be over quickly. Longer term, however, technological innovations that kept inflation low for the last 30+ years continue unabated. Technology begets technology. Remember, were it not for the pandemic, our economy would not have been granted such easy money nor suffered from supply chain disruptions. These are the main causes of our current inflation problem, recognizing that Putin's war only exacerbated it.

Notwithstanding expectations that we may see some improvement on inflation soon, we want to give the market at least this summer to adjust to longer term inflation expectations and this year's dramatic change in Fed policy. So for now, our strategy remains the same as last quarter: 1. avoiding long term bonds 2. holding equities that benefit from higher interest rates 3. avoiding high P/E "long duration" stocks - though their valuations have improved greatly 4. holding some equities as hedges against even higher inflation, such as energy 5. considering inflation advantaged private alternatives 6. Looking for opportunities in the volatile market to upgrade selection and 7. holding ample reserves.

Focus List Slides -7.3% in 1st Half
- vs - 20% for S&P 500

For Q2 the FL was off by -12.3 vs -16.1% for the S&P 500. The 5 year annualized return of the FL was 13.04% vs. 11.30% for the S&P 500. Since inception over 10 years ago, the Focus List has outperformed on an annual basis 15.60% vs. 13.68% for the S&P 500.

We can't hedge against wage inflation, but we can try to hedge against commodities such as copper and oil. Our worst performing stock (-28%) this year was Anglo American which, as you may recall, was purchased as a hedge against much higher inflation in commodities such as copper and nickel. Hedges are like insurance, you don't want them to pay off. Shortly after we purchased Anglo American, copper prices declined sharply which means that at least some components of inflation are backing off.

Owning cyclicals like home builder Lennar and chip maker Micron Technology in the face of a downturn can be volatile. That’s why their stocks are down some 40% this year. Notwithstanding the near term challenges, the long term looks bright for these two out of favor strong competitors. Hence, we are adding them to the list.

For individual stocks as well as selection strategies, past performance is not necessarily indicative of the future.

Hall Capital Focus List

Allstate - strong brand. Strong balance sheet. Hedge against higher interest rates. Steadily higher dividends.
Verizon - largest cell phone service provider in the US. Some debt but safe 5% dividend yield.
Royal Dutch Shell - lowest multiple of the global energy giants. Leader in LNG. 3% secure dividend yield.
NovoNordisk - Danish company has 50% of the global market for insulin. Strong balance sheet.
Alphabet - Google is the "oxygen of the internet". Leader in AI and many other forward technologies. Cash on hand >$135 billion.
CVS Health - with Aetna insurance and growing in store clinics, the chance to become the most integrated health care company.
Apple - brand with 1.4 billion users providing new growth opportunities in service revenue and wearables.
Corning - technological leader in glass for fiber optics and displays.
Goldman Sachs - Wall Street's premier investment banking firm. Stock trading near book value.
Medtronic - world's largest medical device company. Sales should recover when hospitals inevitably return to normal.
Unum - established life and disability insurance provider whose depressed stock price should benefit from higher interest rates.
Meta Platforms - controversial dominant social platform which 60% of US use daily. Trades now at less than a market multiple due to sharp decline in stock price.
Micron - a leader in memory chips with strong balance able to withstand a cyclical downturn.
Energy Select SPDR - hedge against energy driven inflation.
Lennar - a leading home builder facing near term slump in sales but long term opportunity as affordability improves. Strong balance sheet.

Follow Up – from our letter one year ago

"First the obvious: the economy is opening up in earnest with pent up demand; fiscal policy is distinctly stimulative...All the while, the Fed is intent on keeping short interest rates near zero."
- Well guess what, much higher inflation ensued.

"In the capital markets the yield on the 10 year UST has held steady at around 1.5% and the stock market has advanced to new highs. Do investors not care about inflation and potentially higher interest rates? Trust me, they care."
- We are seeing that in spades this year.

"… given the current situation of both stimulative fiscal AND monetary policy in the face of an already recovering economy, we prefer some hedges against the scenario of more persistently higher inflation and higher interest rates."
- The Fed now admits it was too easy for too long.

"It's better to miss the party than to suffer the hangover."
- Yup.

NOTE: Now in addition to ALL our quarterly letters, on our website is a tab with just the Follow Ups.

About HALL CAPITAL

HALL CAPITAL, LLC is a registered investment advisor and was formed by Principals from Arcturus Capital in 2010.
For more information, contact Donald Hall 626 578 5700 x101 dhall@hallcapitalmanagement.com

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